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Tuesday, 4 February 2014

TD says Canadian Housing Market Overvalued by 10% to 25%

The Canadian housing market is overvalued to the point that even banks agree that real estate is too expensive. However, the real question is how much is the market over stretched. In yesterday's report TD agreed with Deutcshe Bank that real estate in Canada is overvalued by 60% against rents and 30% against incomes.
Yet, TD points out that price-to-rent is fundamentally flawed due to rent controls. Furthermore, TD argues that overvaluation against wages depends on how you define income. Hence if you broaden the definition of income to include government transfers and investment income then the housing market is only overvalued by 8%.

Furthermore TD states that what really matters is housing affordability. Therefore if you account for current emergency interest rates, housing is actually undervalued by 6%. However, if interest rates were to return to the long-run average (7%) then housing would be overvalued by 25% on the affordability measure. TD expects that by the end of 2015 housing will be overvalued by 10% due to rising rates.
The thing is, TD's report is mostly marketing propaganda and here's why.

What TD is trying to do in their report is to discredit the old school methods of measuring price overvaluations (price-to-rent and price-to-income ratios) and promote their own affordability index which sugar coats reality.

The reason for this is that old school methods point to a Canadian housing bubble while the affordability measure does not!

Let's start with TD bashing price-to-rent ratio. Specifically, the report mentioned: "This ratio is fundamentally flawed. There are number of rent control measures put in place by provincial governments that restrict landlords from raising rents on their current tenants." "Nonetheless, who's to say the problem has been the sharp increase in prices, and not that rents are to low."

In case you didn't know, there are no rent controls in Alberta and condo rents for 1 bedroom apartments in Toronto (no rent control either) declined in Q4 2013.

Look - none of the overvaluation measures are perfect. Neither the price-to-rent nor TD's affordability index. All of them have issues but what TD is doing is marketing their own agenda.

With regard to the price-to-income ratio, TD says that calculating income based just on what you earn in the workforce is also flawed. You see, you've got to include investment income. So in case you own an investment condo and it appreciated in value, you have to include capital gains in your income calculations. Remember I talked about data manipulation in one of my posts? Well TD is doing exactly that with their disposable income-to-price ratio.

Finally, TD presents their affordability index. According to their calculations if interest rates were to return to 7% then housing in Canada would be overvalued by 25%.

Note that the housing affordability index is highly sensitive to interest rates. Another big flaw of their index is that it assumes a 25% down payment. The issue with here is that down payments have shrunk over the years. Hence mortgage payments do no represent the comparable percentage of income.

An additional caveat is that when interests rates were high in late '80s/early '90s, inflation was also high. When inflation is high, debt depreciates faster which is not the case in the current low interest rate environment.

You might be curious how unaffordable housing in Toronto is. According to TD's calculations, mortgage payments on the average home in Toronto in 2013 took up 42.7% of the average household income.

Thus, TD forecasts home prices in Toronto to increase by 2.7% in 2014 and decline by 1.2% in 2015.

Overall, TD expects that housing imbalances will unwind gradually over the next few years due to modest price correction and moderate income growth.

Too bad TD is full of shit and the proof for that is their expectations of moderate income growth. Look - wages in Canada have been stagnating since the late '70s. But somehow amidst a housing correction TD magically expects incomes to start growing at a moderate pace. Simply delusional!

Below is a chart adjusted for inflation which shows a relationship between wages, condo prices and monthly mortgage payments for Toronto.

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